Economics 29/7/10: PTSB house prices

PTSB/ESRI house price index is in for Q2 2010. The core result: house prices were down, again, by 1.7% qoq in Q2 2010 - a lower rate of change on Q1 2010 contraction of 4.8% qoq. Thus, prices are now off-peak by 35% to an average of €201,364.

Dublin prices are down 3.5% qoq in Q2 2010 and are off 44% relative to peak. This gap between nation average and Dublin, assuming (as seems to be reasonable) that capital prices appreciation prior to the current crisis were significantly affected by underlying demand, should be erased over the next 12 months plus. Which means we can expect at some point that Dublin will lead the recovery across the country, while other regions continue to contract toward the 45-50% nationwide average off-peak pricing.

NCB stockbrokers gave a good comparison to fundamentals-determined prices. Per their analysis,

• Rental yield model implies house prices equilibrium at between €118,000 and €157,000, or a mid-range house price of €137,500;
• Earnings multiples model implies €170,000;
• Present value model (although not detailed as to the assumptions built in) implies the range of €158,000 to €236,000 for an mid-range of €197,000

You can see where these valuations are heading, don't you? Take a full range of estimates mid-range point of €177,000 - that would be a decline of 43% off the peak prices. Take the simple average price of all mid-range points to get 46% decline.

Now, recall - these are equilibrium prices. In normal price adjustments, there is a relatively pronounced undershooting in prices - in other words, we can expect prices to fall below equilibrium levels before reverting toward longer term values over time.

The depth of this undershooting and its duration depend on some external factors, such as the ease of getting mortgages approvals, mortgage conditions etc - none of which are currently helping the housing markets. So there is a very strong possibility for prices to hit the floor at around -55-60% off the peak.

Lastly, there is a question to be asked as to the validity of PTSB's data - the country largest mortgages holder might no longer be the country largest mortgages issuer. And the sample size globally has shrunk substantially. In other words, if a desperate homeowner in the distant province sells a house for, say, €120,000 while a dozen of his neighbors are not braving the market, does this really tell us anything about the market clearing price? Not really. Imagine what the said homeowner would have got for his dwelling if 12 more identical dwellings in the neighborhood had a 'For Sale' sign.

So a grain of salt is due - the size of an orange...

Economics 27/7/10: Stress tests of Irish banks? Get real!

An excellent comment on AIB and BofI 'stress tests' results from Peter Mathews, worth a direct post (rather than 'just' a comment) on this blog. Read it here.

Economics 26/7/10: Old Capital Investment 'news'?

Updated: per some detailed feedback from the DofF, see updated text below.


The latest announcement of the extended capital investment programme for 2010-2016 is sounding like a PR exercise. Majority of the projects announced in the programme are the left-overs from the previous National Development Plan. So there is no real news on spending volumes / stimulus extent in the Taoiseach's announcement.

This does not imply that the programme is without a merit, but it does imply that the media circus about 'major new investment programme' announcement is seriously overdone.

There are, however, some details worth covering.

First, the level of 'new' investment. At €39 billion over 7 years it is hardly a 'significant' increase on the historic levels. Taken as an average of 2008-2010 gross voted capital spending, the six year plan that would have stuck to the average would imply a capital spending of over €51.8bn through 2016. Well in excess of Mr Cowen's latest 'Great 7-year Leap Forward'.

DofF latest projections submitted to the EU in SPU2010, prepared in December 2009, show expected capital investment of €5,500 per annum in 2011-2014, which, is now exactly matched by today's 'new' announcement.

Chart below illustrates, drawing on data from Department of Finance own projections delivered for the Budget 2010.

The news component of the announcement is in the detailed breakdown of the numbers by department and within departments - by the specific lines and projects. This is a significant improvement on the SPU 2010, where the same €5,500 million in annual investments was just a number. And then there are cuts in some of the really less economically feasible (or I would say 'White elephant') investments envisioned in the original NDP.

These are welcomed changes that are worth the report that DofF did produce to accompany the announcement (links here). Where credit due...


Second, Department of Finance SPU submission to the EU has built in (Table 9: Additional Annual Measures to be delivered in 2011 and 2012) as "Capital already identified and incorporated into the base" the following cuts to capital investment: 2011=1bn, 2012=2bn.

If Taoiseach's announcement relates to the new investment on top of the planned NPRF contributions, then the future (2013-2014) savings will have to come out of some other lines of Exchequer balance sheet. Croke Park deal effectively closed the doors on generating new savings from the non-welfare lines of current spending. This means that our Taoiseach, in making today's announcement will be aiming for clawing at least €3bn in new taxes on top of the at least €2bn already planned in Budget 2010 for the years 2011-2012.

Now, recall that the same SPU - which is now replicated in the 7-year plan for capital investment - had its validity questioned by the IMF as being too optimistic on the assumptions, imprecise on planned savings and at a risk of failing due to the possible Government fatigue to cuts. Are we now seeing the very things that IMF was warning us about unfolding in front of our eyes. The IMF also said that it is likely that the additional (not planned in SPU) adjustments to fiscal balance will require savings and/or tax increases of ca 2.3% of 2014 GDP, or roughly speaking €5bn.

So in the nutshell - either we will be borrowing more to finance that which we already announced years ago, or we will be taxed to death to pay for it. Or both.


Oh, and on a funny note - the Irish Times (here) reported that Government is hoping that the new 'investment' will create some 270,000 new jobs, directly and indirectly.

My original comment was: so we spend ca €6,500 mln to generate 270,000 new jobs? At this rate of 'expected' jobs creation, we should have some 6.5 million workers in Ireland, using 2009 GDP levels. Was someone in the Government buildings smoking something funny coming up with these numbers?

A person close to the report came back to me with their explanation of the numbers. The figures quoted on the aggregate are multi-annual 6-year forward projections that incorporate previously announced jobs targets from IDA and EI. So the direct jobs creation (remember - indirect jobs creation is highly uncertain, while IDA and EI targets are not subject to the announced investment measures) is around 1/2 that number. Now, at 130-140,000 per 7 years and at €39bn total would be in the region of €280-300,000 per job in one-off gross investment.

It still looks to me like something a tad too optimistic is happening here:

• Suppose we spend €5,500 million in year 2011 building stuff. This means we hire builders etc. Suppose we manage to get them at a pittance of €100,000 per job (a very low number). We just increased employment by 55,000.
  
• Suppose in 2012 we spend €5,500 again on building some more stuff, plus spend more funds on running the stuff just completed in 2011 (remember, we cannot use €5,500mln allocation in 2012 to operate the stuff just built in 2011, as it would be a current expenditure item). So we have to hire new and re-hire old, but the same number of 55,000 workers.
  
• Between 2 years, new jobs creation is 55,000. Not 110,000.
  

And this is what worries me here. Despite the explanations I got from DofF, the document numbers on the jobs front still do not add up to me.

Worse than that. Some of the programmes envisioned in the plan will require people to run/operate them in the future, post-construction, and will also require considerable spending of funds on amortization and depreciation, maintenance and operations.

Are there any estimates as to what will be the budgetary impact of these 'new investments' on the current expenditure in the future?

Let me explain here. Suppose I spend €2mln building a school building. Unless I get the existent staff to run the building, I will have to hire new teachers, new service providers, and I will have running and operating costs. For a school, suppose I will need 2 teachers and 1 service personnel (split into part-time admin and part-time maintenance staff). That's ca €150K annually in wages, plus mark ups for pensions etc - roughly speaking €280-300K per annum. Utilities etc, plus scheduled maintenance, say another €50K. So my initial investment of €1mln creates a continuous liability of up to €350K. Of course, I can cut my construction workforce hired in 2011 and divert 'investment' to funding staff operating my new facility. But that makes it a current expenditure. And it means that the rate of jobs creation will be crowded out over time by the newly added infrastructure demands.

Note, these are illustrative figures, but they add up.

• In 2012: projects from 2010 come on-line, implying (using above assumptions) that current spending side swells by €1,100 million (gross side);
• In 2013: projects from 2011 come on-line, yielding another €950mln, adding to 2012 to generate a permanent increase in gross current spending of €2,050mln.
• and so on...

These are crude illustrations, but you get my concerns? Yep - these current costs will have to be paid by us, the taxpayers. And it scares me.

And yes, I still do not believe that 270,000 figure. In fairness to the DofF - they have been stressing since yesterday that the figure is there just because they needed some anchor to the economic impact. It is neither rigorous, nor definitive.


Lastly, I would like to thank DofF for engaging in the debate and providing some very fair clarifications and explanations of their position on the paper.

Economics 25/7/10: What lending markets tell us about EU policies

So the markets are not that enthused about the stress tests. After the initial bounce on the back of 'pass' grades, there are rising concerns about some 19 banks, including AIB, which were given 'all clear' with some serious stretch of assumptions.

But to see what is really going on behind the scenes, look no further than the actual interbank lending rates. In fact, the interbank lending markets provide a good reflection on the combined euroz one policies enacted since the beginning of the Greek debt crisis. Both euribor (the rate for uncollateralized lending across euro zone's prime banks) and eurepo (lending rates for collateralized loans between euro zone's prime banks) are significantly elevated on twin concerns about:

1. The quality of the borrowing banks (recall - these are prime banks); and
2. The quality of the collateral (with sovereign bonds being top tier quality, deterioration in sovereign debt ratings is hitting interbank markets hard).

Here are the usual, updated charts:

Chart 1Long maturities have been signalling extremely adverse effect of the Euro rescue package since its inception.

Medium-term maturities show severe deterioration since the euro rescue package. Steepest, and uninterrupted rise in 3 months euribor signals that the rescue package is faltering in delivering anything more than a buy-time for the euro… In other words, we have an expensive (€750 billion-sized) buy-in of short time.

The ECB claw back on longer term lending window did not help this process either. But the stress tests are doing nothing to stop the negative sentiment dynamics.

Chart 2Per chart 2 above, short-term maturities are showing that despite supplying underwriting to about a half of the full year worth of euro area bonds refinancing, the rescue package has achieved no moderation in the short-term risk perceptions of the market. In fact, the rise in euribor is more pronounced in the short term than in longer maturities, suggesting that short term risks of sovereign default remain unaddressed by the rescue package and are exerting a continuous pressure on interbank lending.

Introduction of the stress tests also did nothing to reduce overall cost of borrowing amongst the prime banks which were fully expected to pass the test even before the EU got on with setting test parameters.

In turn, all of this spells much higher costs of funding for the banks which have shorter term financing needs, such as the Irish banks. The implicit cost of taxpayers’ guarantee for Irish banks debt is therefore rising.

And panicked markets are not about to surrender their fears to the EU PR machine. With all the increases in the euribor, the volatility of the interbank lending rates also increased, across all maturities, as shown in charts 3 and 4 below.

Chart 3Chart 4As evident, in particular, from chart 4, in the longer term, credit markets are absolutely not buying the combination of the EU rescue package, ECB liquidity measures and the stress tests. Euribor trajectory for maturities of 6 months and higher firmly re-established and vastly exceeded volatility that preceded the pre-rescue panic. We are now worse off in terms of the cost of banks financing than we were before the Greek crisis blew up.


To remind you - eurepo is the rate at which one prime bank lends funds in euro to another prime bank if in exchange the former receives from the latter the best collateral in terms of rating and liquidity within the Eurepo basket. Eurepo rates have posted dramatic increases since mid-June 2010. The original effect of the June 2010 closure of the longer maturity (12 months) ECB discount lending was a temporary reduction in the rates, followed by a stratospheric rise two week later that has been sustained through the end of this week. This is especially true for shorter term maturities, suggesting that part of the adverse effect was due to the heightened uncertainty around the EU stress tests. Chart 5 below illustrates.

Chart 5Chart 6The u-shaped response in the interbank lending rates to ECB lending changes and to stress tests is even better reflected in the longer maturity eurepo rates, as highlighted in chart 6 above.

3-months and 12-months eurepo rates are now at the levels consistent with the height of the sovereign default crisis. There are significant differences in the rates by maturity group and vis-à-vis euribor due to the fact that the quality of collateral offered in the markets is now itself uncertain as sovereign credit quality continues to deteriorate both in terms of increasing probabilities of default and thus associated risk premia, but also due to the regulatory treatment of collateral that is being signalled by the stress tests.

As with euribor, eurepo rates are showing remarkable increases in volatility, for both shorter and longer term maturities.


Let us finally put the two rates side by side to compare evolution of euribor against eurepo, setting index for all at 100=January 4, 2010

Chart 7Chart 8
Some pretty dramatic stuff. To round off, recall that since the beginning of April 2010, the eurozone has undertaken the following measures to shore up its financial markets:

1. Set up a sovereign rescue fund worth more than €750 billion to underpin roughly 50% of the total borrowing requirement in the euro zone (which could have been expected to yeild an improvement in banks collateral and thus a reduction in overall systemic risks in the interbank markets as well);
2. Reduce maturity profile of ECB lending window (which was from the get-go equivalent to dumping more petrol on the forest fire);
3. Deploy aggressive quantitative easing by the ECB (again, this should have reduced uncertainty in the interbank markets as in theory improved pricing for sovereign bonds should have increased the quality of interbank collateral and improve banks own books);
4. Conduct an absolutely discredited stress test of the banks (designed to provide positive newsflow for the banks, especially for prime banks which should have seen their risk profiles reduced by a mere setting up of the test).

In short, none of the measures seem to be working, folks... May be, just may be, the real problem with EU banks is their unwillingness to come clean on loans losses and start honestly repairing their balancesheets?

Economics 22/7/10: EU stress tests - what do they tell us, really?

The EU stress tests of the banks confirm the worst fears of all analysts – including myself. The tests were simply a PR exercise, so poorly conducted that no one can have any credibility in their outcomes. Worse than that, the whole circus:

• The difficulty with which the EU member states appeared to be willing to release information about the tests;
• The way in which information is being released (via a drip feed – bit by bit over time, with massive leaks beforehand);
• The struggle through which member states have gone in order to even agree to carry out the tests in the first place;
• The rhetoric from the EU regulators assigning an almost heroic quality to its efforts to test the banks in the face of a clear shambolic nature of the whole exercise.
  

All of these things provide for a strong suspicion that the EU will not be able to undertake robust regulation and monitoring of the euro zone banking system in the future, plus a clear cut realization that the entire idea of the euro member states coming together to police their own fiscal behaviour will be even less honest, transparent or robust. In other words, how can we expect the EU to act as a functional policeman of its members fiscal policies if:

1. It failed to do so over years past, even armed with already robust and automatic regime of the Stability & Growth Pact, and
2. It failed to properly stress test its own banks?
   

In the nutshell: German banks, including Landesbanken, have already privately leaked the ‘news’ that they all had passed the test. Ditto for banks in France, Ireland and Italy. Only one German bank – already failed HRE – has failed the test from among 91 institutions.

In the case of AIB – the sick puppy was ‘passed’ by allowing to include into regulators’ calculations the €7.4 billion the bank plans to raise by the end of 2010. Good intentions count for hard evidence, then, per EU regulators. And Bank of Ireland passed - along with all the rest of the PIIGS banks is by the test excluding any possibility of twin shocks - simultaneous continued deterioration in quality of loans and a sovereign debt crisis. Now, in all likelihood, if the sovereign debt crisis continues to rage, does anyone in their right mind thinks that housing and other asset markets in the likes of Ireland and Spain are going to improve to alleviate the loans book pressures?

Farcical!

What the 91 tested banks did ‘pass’ was not a stress test, but a joke, concocted either by those with no understanding of banking (Eurocrats?) or created specifically with an ex ante intent of passing them all. The French and Greek banks privately said that the haircut applied to their holdings of Greek government debt were about 23%. Markets are factoring in 50-70% haircuts, so the EU stress test was less than half as severe as what is being priced already. Worse than that – the sovereign debt haircuts were applied only to bonds held in banks’ trading books. That accounts for just 10% of all Greek bonds held by the euro area banks, as 90% of Greek sovereign debt has been already moved to ‘held to maturity’ parts of banks assets portoflia, not reflected on trading books.

In other words, when it comes to Greek sovereign debt exposure, the EU tests were capturing no more than 5% of the total risk of such exposure for the banks. Like a doctor, looking at the brain activity chart of the patient and saying: ‘Look, there’s no activity at all. But 95% of all other vital signs are performing just fine. Indeed, no worries old man, the patient is still looking 95% alive then…’

And there's more. Per media reports, a memo from Germany's Financial regulator BaFin earlier this year said the real concern should be contagion from "collective difficulties" across the PIIGS, not an isolated default of Greece.

All of this did not prevent Irish stockbrokers from issuing upbeat reports about 'the good news' for BofI and AIB. What good news? The shares in two banks rallied today because someone, somewhere, allegedly decided that if Greece softly defaults, Irish banks will survive? Did that someone actually paused for a second to think, before placing a 'buy' order if Irish banks can survive their own home-made disasters? Or whether they can survive a meltdown of Greek debt default as priced by the markets? Or whether they can survive both happening at the same time?

Irish analysts, who issue these forecasts should be required to read Taleb's 'Fooled by randomness', though one wonders if they will understand much of what Taleb is saying for years now. Investors who chose to belive that AIB and BofI passing of the 'test' this week is some sort of a 'good news' are simply fooling themselves by ignoring a simple fact of life - misdiagnosing a patient with heart attack as being free of an Avian flu is not going to improving the patient's chances of survival. It actually reduces them.

Shamed by this absolutely incompetent, if not outright markets manipulating ‘testing’, you’d think the EU leaders would step back and start an earnest conversation between themselves as to what has gone wrong here. Nope. They are hell bent on creating more Napoleonic sounding, but utterly unrealistic and even disastrously risky plans. This time around – for fiscal harmonization. France and Germany – the two countries that have been clearly at odds with each other in responses to the current crisis have decided that a bout of amicable activism is long overdue. So behold the latest Franco-German alliance on a list of fiscal policy co-ordination proposals.

Per reports in today’s media: a French cabinet meeting took place with German presence, during which Sarkozy called for a complete harmonisation of European tax systems. ‘He did whaaat?!’ I hear you cry… yeah, he did call for that which was explicitly denied by him and the entire EU leadership core as ever having a chance of happening in the run up to the Lisbon II referendum in Ireland.

Now, don’t take me wrong here – this is not a voluntary call for individual states cooperative action – it is a call for an EU-wide ‘reform’. And if you don’t think so, the same meeting called, once again, for member states with excessive deficits to be punished by withdrawal of voting rights in the Council of Ministers, plus a fine and the compulsory imposition of an interest-bearing deposit for member states.

Eurointelligence blog has put it succinctly: “In other words, France and Germany [have called] to continue the same dysfunction regime, except that they strengthen those parts that have prove the most dysfunctional.”

Let me be a tad controversial here - wasn't all of this predicted to happen by Declan Ganley, Anthony Coughlan, Mary Ellen Synon and others who argue in favour of democratic reforms in the EU? Weren't they 'refuted' on exactly these predictions by the entire 'establishment' in Brussels and the all-knowing dons of the Upper Merrion Street? You don't have to agree with their points of view. You might as well agree that the idea of fiscal harmonization is a great thing. But what cannot be denied is that:

1. Any policies absent meaningful ability to honestly, transparently and effectively enforce them (and EU has shown none of these in its stress tests of the banks - the easiest area to deliver them in current political and economic environment) is destined to be nothing more than a bullying pit for some states to arbitrarily control others; and
2. Given grave doubts about EU's capabilities to provide for (a), the automatic default option of any new policies should be to scale opportunism and adopt pragmatic, cautious, incremental reforms approach - when in doubt, measure and caution must be the prevalent guide.
   

After all, if I were a person with the power to shape EU principles, I would adopt the milenia-old medical code of ethics, that is based on the fundamental axiom of morality: Primum non nocere, or First, do no harm.

Then again, adopting such a principle would have meant not conducting these 'stress tests'.

Economics 22/7/10: Irish bonds auctions - a Pyrrhic victory?

“Despite Moody’s downgrade on Ireland’s credit rating on Monday, the NTMA successfully borrowed €1.5bn yesterday. Yesterday’s auction showed increased demand from investors for Irish debt and now means that the NTMA has completed 90% of its 2010 long-term borrowing programme.”

That was the swan song from one of Irish stock brokerages.

Lex column in the FT was far less upbeat, saying Ireland “offers a not terribly encouraging example of how difficult it is to overcome a massive debt binge.”

NTMA might have pre-borrowed 90% of this year’s €20bn borrowing target . But two things are coming to mind when one hears this ‘bullish’ statement.

Firstly, the €20bn is a target, not the hard requirement. If banks come for more cash, Brian Lenihan will have to get more bonds printed.

Secondly, Irish spread over German bunds is now higher than it was at the peak of the crisis in early 2009.

Want see some pictures illustrating Irish borrowing ‘success story’?

Let us start on the shorter end of maturity spectrum – 5 years and under:

Chart 1Average yields are trending up over the entire crisis term and are soudly above their entire crisis trend line since June. More significantly, the trend is now broken. As yields declined in 2009, hitting bottom in October, since then, they have posted a firm reversion up and once again, June and July auctions came at yields above those for this dramatic sub-trend.

Worse than that – in complete refutation of ‘improved demand’ claim by the brokers – yield spreads are now elevated. This spread – the difference between highest yield allocated and lowest yield allocated – suggests that markets are having trouble calmly pricing Irish bonds issues. Success or psychosis?

Chart 2 below illustrates the same happening in terms of price spreads.

Chart 2Auctions cover for shorter term paper is still below the long term trend line, although the line is positively sloped.

Chart 3Chart 3 above shows just how dramatic was the price decline and yields rise in Q2 2010 and how this is continued to be the case in July.

Chart 4Chart 4 gives a snapshot on pricing.

Next, move on to longer term bonds (10 years and over). There has been only one issue of 15 year bonds, so it is clear that the NTMA is simply unwilling to currently issue anything above 10 year horizon because of prohibitive yields.

Chart 5Chart 5 above shows upward trend in yields and July relative underperformance compared to longer term trends. It also shows yield spreads – again posting some pretty impressive volatility in June and bang-on long-term average (or crisis-average) performance in July. If that’s the ‘good news’ I should join a circus.

Chart 6Weighted average price is not changing much over the crisis period, so no improvement is happening here. In fact, since May it is trending down below the long term trend line, suggesting significant and persistent deterioration. Cover is on the up-trending line, but came in below the trend in June and July.

Chart 7 below shows more details on max and min prices and yields.

Chart 7Chart 8Chart 8 above clearly shows how average price is now in the new sub0trend pattern since November 09 price peak. May-July prices achieved are clearly below long term trend line and even more importantly – below the sub-trend line.

Finally, chart 9 shows the maturity profile of auctioned bonds:

Chart 9Notice how before the 2014 deadline, the Exchequer is facing the need to roll over €6,381 million in bonds issued during the 2009-present auctions. If Ireland Inc were to issue more 3-year bonds, that number will rise. That should put some nasty spanners into Irish deficits-reduction machine. But hey, what’s to worry about – our kids will have to roll over some €21,264 million worth of our debts (and rising), assuming the Bearded Ones of Siptu/Ictu & Co don’t get their way into borrowing even more.

Let us summarize the ‘success story’ that our brokerage houses are keen on repeating:

Table 1In other words, we are now worse off in terms of the cost of borrowing than in January 2010 – despite the ‘target’ for new issuance remaining the same throughout the period. We are even worse off now than at the peak of the crisis in March-April 2009 in short-term borrowing costs, although, courtesy of the German bund performance since then, we are only slightly better off in terms of longer maturity borrowings.

The compression in yield term structure delivered in June-July this year is worrisome as well. It suggests that the markets are not willing to assume that Irish Government longer term position is that much different from its shorter term prospects.

So on the net, then, what 'success' are our stock brokers talking about then? The success, of course is that NTMA was able to get someone pick up the phone and place an order, at pretty much any price? Next time, they should try selling pizzas alongside the bonds - the cover might rise again and they might convince the Eurostat that pizza delivery services are not part of the public deficit...